EU Weighs Curbs on Banks’ Use of Client Assets as Collateral

May 24 (Bloomberg) -- Banks and brokers face a clampdown on
using assets they hold for clients as collateral for their own
trades as part of European Union moves to bolster market
stability and rein in shadow banking.

The European Commission is weighing whether firms should
have to obtain formal consent from their clients before being
allowed to reuse assets to back other trades, according to a
document obtained by Bloomberg News. The consent would be
enshrined in a “contractual agreement” between the parties.

The handing over of collateral is an integral part of
repurchase agreements, or repos -- one of the activities under
review by global regulators as part of their efforts to regulate
shadow banking. The reuse of clients’ assets poses a potential
threat to financial stability should one of a chain of firms
that handled the securities go bankrupt, according to the
document prepared by commission officials and dated May 15.
Uncertainty about who holds an asset can fuel panic in times of
market stress, according to the paper.

“Complex” chains of collateral can make it difficult for
investors to “identify who owns what, where risk is
concentrated and who is exposed to whom,” according to the
document. “This has consequences for transparency and financial
stability.”

Under the plans being weighed by the commission, banks and
brokers holding securities for clients wouldn’t be allowed to
reuse the assets for trading on their own account -- speculation
on the markets aimed solely at boosting their own revenues,
according to the document.

Repo Trades

The EU market for repo trades, contracts in which one
investor agrees to sell a security and then buy it back at a
future date at a fixed price, is worth more than 5.6 trillion
euros ($7.2 trillion) according to the most recent survey
published by the International Capital Market Association.

Repos are a major source of short-term finance for banks,
allowing them to use securities as collateral for short-term
loans from investors such as other banks or money-market mutual
funds.

The Financial Stability Board has estimated that the global
shadow-banking system was worth $67 trillion in 2011, with EU-based activities accounting for about $31 trillion.

Systemic Risk

Shadow banking is a term used by regulators to define
activities that fall outside the scope of most banking and
market regulation, and which they believe could be a source of
systemic risk. The FSB has identified repos, securities lending
agreements and securitization as examples of shadow banking
activities.

Evolutions in how markets function mean there is a need for
EU rules, according to the document.

“Securities are credited to accounts reflecting a virtual
rather than physical nature and EU laws covering securities have
not kept pace with market innovation,” according to the
document.

The commission is concerned that “legal gaps and
inconsistencies” are hampering transparency over the ownership
of securities “and can create legal risks in cross-border
securities holding and dispositions,” according to the
document.

Chantal Hughes, a spokeswoman for Michel Barnier, the EU’s
financial services chief, declined to immediately comment on the
document.